article discussion Flashcards
tight monetary policy
refers to a set of actions taken by a central bank
to REDUCE the MONEY SUPPLY and CURB INFLATION
goals of tight monetary policy
(reduce money supply and curb inflation)
- slow down economic activity
- control inflation
- prevent economy from overheating
key actions associated with tight monetary policy
- raising interest rates
- selling government securities
- increasing reserve requirements
raising interest rates (in context of tight monetary policy)
when central banks increase interest rates, borrowing becomes more expensive
leads to less borrowing and spending by businesses and consumers
selling government securities (in context of tight monetary policy)
by selling bonds, the central bank reduces the money supply in the economy
as people exchange money for bonds
increasing reserve requirements (in context of tight monetary policy)
central banks may require commercial banks to hold more reserves
which means they have less money to lend out, further restricting the money supply
explain the transmission mechanism implied by the author when he says that “higher interest rates in America can cause a rise in unemployment”
- higher interest rates increase the cost of investment and consumption
- investment and consumption decrease
- AD shifts to the left, reducing output
- a reduction in output increases unemployment
elaborate on how increase in interest rates can potentially trigger a housing market crash, and what repercussions this would have for the US economy
- increased interest rates increase the cost of borrowing for homebuyers. the affordability of mortgages decreases. this leads to a decrease in the demand for housing
- lower demand for housing can cause prices to drop
- this is a negative wealth effect that could lead to a reduction in consumer spending
- this can be represented by a leftward shift of the AD curve
- this would move the economy into an equilibrium with lower GDP and higher unemployment
negative wealth effect
refers to a situation where a DECREASE in the VALUE OF ASSETS (stocks, real estate, other investments)
leads to REDUCTION IN CONSUMER SPENDING
when people feel less wealthy (because the value of their assets have declined), they cut back on spending
this hurt businesses, leading to slower economy and unemployment
provide an explanation for why the author claims that “tight money has brought about a strong dollar”
- tight money policy aims to curb inflation by reducing the money supply
- this reduction means that the interest rate in Canada will increase
- the high interest rate will attract investment from abroad
- this investment will lead to an appreciation of the Canadian dollar, as in order to buy Canadian bonds people must convert to Canadian currency
consider emerging market economies - explain why a strong dollar is causing inflation to be exported to emerging markets
strong dollar causes inflation to be exported to emerging markets primarily through its impact on INTERNATIONAL TRADE
1a) when the US dollar strengthens, it can lead to an increase in the prices of IMPORTED PRODUCTS in the LOCAL CURRENCIES of EMERGING MARKETS
1b) this is because with a strong US dollar, a higher amount of local currency has to be paid for US imported goods
1c) as the cost of imports rises, it can DRIVE UP INFLATION in emerging markets (imported raw materials, inputs - so inflation is passed on to consumers)
2a) furthermore, a strong dollar can lead to CAPITAL OUTFLOWS from emerging markets as investors seek HIGHER RETURNS in the US
2b) this depreciates their currency even more, making imports increasingly expensive
“Europe is grappling with a severe energy crisis that’s shutting down factories and hurting consumers” - represent in a diagram with AD and AS the effects of the energy crisis in Europe
- the energy crisis shutting down factories implies a reduction in aggregate supply
- this means that the AS curve is shifting leftward as a result of reduced availability of energy resources
- this implies decreased production ability and increased production costs
- equilibrium output will decrease and price level will increase
- this means there has been a recessionary effect on the European economy, with high inflation
discuss why the author says that “the severity of the downturn depends significantly on the weather”
weather conditions can affect the impact of the energy crisis
severe weather conditions (extremely cold winters or heatwave) exacerbate the energy crisis by increasing energy demand for heating or cooling
such conditions further strain energy resources and infrastructure, leading to more severe disruptions in energy supply and greater economic consequences
consider the Chinese economy - use an AD and AS diagram to rep the effect of “the housing-market crash and zero-covid policy” of the Chinese economy
- both factors contribute to a leftward shift in AD curve
- housing market crash reduces household wealth and consumer confidence, leading to decreased consumer spending
- zero-covid policy introduces stringent lockdowns and restrictions, making consumption difficult as people face hurdles in spending due to limited access to goods and services
- these measures directly impact investment and consumption, further contributing to AD’s leftward shift
- zero-covid policy complicates work and lower labour force participation - disrupts normal functioning of businesses and makes it hard for employees to physically attend work
- reduces labour productivity and capacity - this leads to a leftward shift in the AS curve
COMBINED EFFECT OF HOUSING MARKET CRASH AND ZERO COVID POLICY RESULTS IN LOWER AD AND LOWER AS
this leads to reduced equilibrium output, indicating an ECONOMIC SLOWDOWN in China
explain tensions between FISCAL and MONETARY policies, with a focus on Europe. discuss origins of these tensions, considering diff priorities of central bankers and politicians. use AD and AS curve to support your explanations
in Europe - tension between fiscal and monetary policy arises from a NEGATIVE AS SHOCK (specifically, high energy prices)
shock reduces output and raises prices
central bank targets inflation by increasing interest rates to shift AD leftward (lowers prices - reduces inflation)
simultaneously, governments are concerned about economic outlook - and they may implement expansionary fiscal policies to boost AD (shift AD rightward)
their aim is to increase GDP but this potentially exacerbates inflation
CREATES TENSION AS FISCAL AND MONETARY POLICIES PULL IN OPPOSITE DIRECTIONS - reflects challenges of addressing negative AS shocks while balancing inflation and economic output
fiscal austerity
set of policies aiming at REDUCING GOV SPENDING and/or INCREASING TAXES
in order to achieve fiscal discipline and REDUCE BUDGET DEFICITS or the size of national debt
how does fiscal austerity contribute to Europe’s growth problem?
- by directly reducing AD
(through reducing gov spending and reducing investment)
- and by indirectly weakening long-run growth potential
explain this statement - “fiscal tightening (cutting deficits) in a weak economy is pro-cyclical”
fiscal tightening (reducing gov spending and investment/leftward AD shift) in a weak economy is pro-cyclical
it reduces government spending and demand when stimulus is needed
this obstructs growth, worsening the slowdown and increasing the risk of stagnation
EU’s structural weaknesses limit its ability to grow
- DEMOGRAPHICS: ageing populations reduce productivity and increase spending on pensions and healthcare, pushing up government costs without boosting output
- FISCAL RULES: (like the EU’s new deficit reduction targets and Germany’s constitutional “debt brake”) force countries like France and Italy to cut deficits by 0.5% of GDP annually, leaving less room for public investment and limiting support for growth-enhancing principles
in class, we discussed that increase in G could increase interest rates and crowd out private investment. do you think the decision of the ECB last week to cut interest rates could help Europe?
- increase in G means governments need to BORROW MONEY to finance their spending - they do this by ISSUING BONDS in the financial markets
- this increases the DEMAND FOR LOANABLE FUNDS (the money available to borrow)
- as gov borrows more money, it competes with PRIVATE BORROWERS in the market for available funds - when demands for borrowing increases but the supply of funds doesn’t change, the COST OF BORROWING INCREASES
- this is reflected in HIGHER INTEREST RATES
- higher interest rates make borrowing MORE EXPENSIVE for private businesses - discourages them from taking out loans to invest in new projects, expand operations, hire more workers etc
^ this is “CROWDING OUT”
YES IT COULD HELP - BECAUSE AD WOULD SHIFT LEFT AS THE COST OF BORROWING DECREASED
if fiscal consolidation reduces potential output growth, how might that in turn affect public finances? could cutting deficits today make it harder to achieve fiscal sustainability in the long run? why/why not?
- fiscal consolidation (austerity) can reduce PUBLIC INVESTMENT in infrastructure, education and research & development
^ this lowers potential output growth over time by weakening productivity and human capital formation
- lower growth = lower future tax revenue
- debt-to-GDP ratio worsens if growth slows
why Biden will need to spend big - discuss how the model covered in class could be used to analyze the COVID 19 crisis
- AD shifted leftwards - people experienced barriers to spending on goods and services
^ led to lower output and lower employment
- AS shifted leftwards - inability to conduct work as normal lowered productivity and decreased output
^ led to lower output and higher prices
- the combined effect of a recession (lower output) and potentially stagflation (higher prices and lower growth)
^ depending on which shock dominates
in the COVID US situation, what’s the effect of an increase in gov investment?
- increases AD through higher gov investment/spending
- AD shifts rightward - increases output and employment
- long term growth via investments in infrastructure, education, technology
^ can enhance productivity and lead to sustainable economic growth
following Paul Krugman’s discussion, why’s the current situation special and why should the gov be less concerned about the cost of debt?
- historically low interest rates
^ gov borrowing is very cheap right now - this means the cost of debt is low, so it’s not a burden to borrow more
- high demand for safe assets
^ investors want to hold safe assets, like US gov bonds. this keeps bond yields (interest rates) low and makes it easy for gov to finance deficits. people are parking their money in a safe place, allowing the gov to borrow without too much inflation risk or competition
- risk of doing too little = bigger than risk of debt
^ if gov fails to stimulate the economy, downturn could last longer
what is a government doing when it issues bonds?
is essentially borrowing money from individuals, businesses and institutional investors
in exchange for a promise to pay back the borrowed amount (PRINCIPAL) plus the interest (COUPON) over a specified period of time
when gov sells bonds, it must attract buyers who are willing to lend to the government - how does it do this?
by offering bonds as a FORM OF DEBT
the gov is competing for money in the SAME LOANABLE FUNDS MARKET where businesses, households and other entities also borrow
by issuing bonds, gov is demanding funds from investors who could have otherwise used their money for private sector loans/investment - so the acts of issuing bonds directly increases demand for loanable funds
with more demand for the same pool of savings, the price of borrowing (interest rates) tend to rise
how does the demand for loanable funds increase when the government issues bonds?
increases demand for loanable funds because now the gov is looking for buyers (businesses, households) for their bonds
gov bonds have appeared on the scene, in addition to existing loanable fund demand form private sector loans/investments
more gov borrowing means MORE COMPETITION for the same supply of funds
this PUSHES INTEREST RATES UP
4 factors affecting the CAD exchange rate
- MONETARY POLICY: higher interest rates attract foreign capital (appreciation)
- FISCAL POLICY: deficits may weaken the dollar, economic growth can strengthen it
- INFLATION: high inflation reduces demand for CAD (depreciation)
- TRADE BALANCE: surpluses strengthen CAD, deficits weaken it
Keynesians argued what?
that monetary policy (manipulating interest rates and the money supply) was not very effective
> MD curve was relatively FLAT
> ID curve was relatively STEEP
means that a change in MD will cause only a small change in interest rates, and thus won’t really affect investment demand
Monetarists argued what?
(led by Friedman)
argued that monetary policy was effective
> MD curve was relatively STEEP
> ID curve was relatively FLAT
means that a small change in MD will cause a big change in interest rates, and thus investment demand
important 1950s-60s debate about monetary policy
- centred around the slopes of the MD and ID curves
- Keynesians versus Monetarists
monetarists versus keynesians - empirical support
much empirical support for idea that MD curve ISN’T FLAT
- changes in money supply DO lead to changes in the equilibrium interest rate
- monetary policy can be effective
“why Biden will need to spend big article” - discuss how the model covered in class could be used to analyze the COVID-19 criss
AD: barriers to goods and services reduced consumption and lowered confidence reduced investment
^ AD shifted left
AS: barriers to combining land, labour and capital reduced output
^ AS shifted left
END RESULT was stagflation: higher prices for lowered output, higher levels of unemployment
“why Biden will need to spend big article” - what’s the effect of an increase in government investment in this situation?
increased gov investment will have short and long run effects
SHORT RUN:
^ increase investment will increase output, leading to rightward shift in AD curve (higher output and higher employment)
LONG RUN:
^ increased investment in things like education, healthcare, technology, research & development increase the productive capacity of the economy & sustainable growth
“why Biden will need to spend big article” - why is the current situation special, and why should the government be less concerned about the cost of debt?
- LOW COST FOR BORROWING: interest rates = historically low, making borrowing more affordable for governments
- HIGH DEMAND FOR SAFE ASSETS: in uncertain times, there’s increased demand for safe assets like government bonds, allowing governments to finance deficits at low costs
- RISK FOR INACTION: not providing adequate fiscal stimulus could lead to prolonged economic stagnation, which may have higher long term costs than increased debt
“will fiscal stimulus overheat the American economy?” - why does the author argue that the downturn may be temporary? why would this be relevant for inflation?
argues that the decrease in employment will likely be short-lived, and that it’s restricted to certain sectors - soon the economic downturn caused by the pandemic will ease as vaccination efforts progress and restrictions are removed
the temporary nature of the downturn is relevant because if expansionary fiscal policy coincides with a natural recovery of demand, then AD may overshoot its target, resulting in higher prices and further inflation
this is the opposite of what the policies had wanted (to curb inflation)
so, recognizing the temporary nature of the downturn is essential in ensuring the fiscal policy doesn’t intentionally overheat the economy
“will fiscal stimulus overheat the American economy?” - explain another force that would reinforce the overheating of the economy
article also points out that households’ spending had decreased
now have more savings
and once restrictions ease, they will want to spend more
AD will shift right, driving up prices if supply doesn’t increase alongside demand
“will fiscal stimulus overheat the American economy?” - explain why Mr Furman says the case for the stimulus to be as large as Mr Biden’s proposal “has to be that you think the multiplier in 2021 is really small”
the multiplier measures the impact of government spending on economic output
if the multiplier is small, then a larger stimulus is needed to achieve the desired economic impact
(small multiplier could be due to high savings rates, supply-side constraints limiting production capacity, and changes in consumer and business expectations about future economic conditions)
what could a small multiplier be due to?
- high savings rates
- supply-side constraints limiting production capacity
- changes in consumer and business expectations about future economic conditions
“will fiscal stimulus overheat the American economy?” - explain why low interest rates may contribute to setting off inflation
REASON ONE: CHEAPER BORROWING
1. low interest rates decrease the cost of borrowing
- lower costs of borrowing mean more people will take out loans
- this increases investment and consumption
- AD will shift to the right
- if AS doesn’t adjust in tandem, then prices will increase and inflation will occur
REASON TWO: MORE EXPENSIVE ASSETS
1. low interest rates increase asset prices (more expensive houses, stocks etc)
- this leads to wealth effects and increased spending
REASON THREE: WEAKENED CURRENCY
1. low interest rates can decrease the value of a country’s currency
- makes imports more expensive and contributes to higher prices
how do banks create money?
by issuing more “promises to pay” than they have in cash reserves
BoC during Covid-19
- gov issued a bunch of gov securities to households/firms whose revenues had collapsed due to the pandemic
- BoC bought these gov securities, thereby expanding the amount of money in the banking system
why are excess reserves important in the process of money creation?
means that the reserve ratio is above target
they can lend out more
more loans = more money in economy = more deposits
process builds and builds
3 reasons why AD curve is negatively sloped
- increase in P = decrease in wealth
- increase in P = decrease in NX
- increase in P = increase in money demand > increase in interest rates > reduced investment
